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Emerging Market Debt: Re-calibrating risk

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Early summer saw volatility back in global markets, and nowhere more so than local currency emerging market debt. Joseph Mariathasan dampens out the noise and re-assesses the underlying fundamental arguments for the asset class

Local currency emerging market debt is an asset class in transition in every sense. It is currently predominantly government debt, as local currency corporate debt relies on the creation of sovereign yield curves, but this is happening and will be transformational for a host of emerging market economies from China downwards.

That is not the only reason why local-currency debt looks a very different asset class today compared with a couple of decades ago. Only 10% of EM sovereign debt was investment grade in the 1990s, while today the figure is over 60%, and yet five-year local currency debt was trading at spreads of 500 basis points over US treasuries in mid-July this year.

“That spread is far too wide,” says Jan Dehn, head of research at Ashmore. “It traded at 174 basis points just before the crisis in 2007-08. Despite everything we have learnt about the resilience of emerging markets since the crisis, investors have still bought developed country debt and sold emerging markets. Local currency debt is fundamentally mispriced.”

But emerging markets have given investors a roller-coaster ride during that time. There were record inflows of local currency emerging market debt at the beginning of 2013, only to become one of the hardest-hit markets in the turmoil following Ben Bernanke’s comments about “tapering” of quantitative easing (QE), in May.

“Many said that the long-term outlook for local currency debt was very poor for a number of reasons – a key argument being that the secular trend for emerging market asset appreciation was over, given the collapse of the commodity boom,” says Magda Branet, EMD portfolio manager at Axa Investment Managers. “I don’t agree with that.”

So what is the prognosis? Separating the short-term impact of rapidly changing market sentiment as a result of policy makers’ musings from structural changes has proven difficult.

“Emerging market local currency debt may not be as compelling now as it was [in April] from a global perspective, but there is still a very strong fundamental story,” says Michael Ganske, head of emerging markets at Rogge Global Partners. “It is not fundamental investors like ourselves who are panicking and creating the volatility, but hedge funds and short-term investors.”

Indeed, it seems difficult to draw any link between Bernanke’s public pronouncements and the longer-term fundamentals of emerging markets. So how significant is this recent market volatility? One needs first to understand the grand themes that drive local currency debt markets.

“We see four or five storms at any time affecting local currency EMD, with different speeds, intensities and directions that can be idiosyncratic to specific countries or groups of countries, or common across emerging markets,” says Sergio Trigo Paz, head of EM fixed income at BlackRock.

He believes that in mid 2013, there are three key themes to be aware of: China; the impact of market volatility on the risk/reward equation; and flows.

Trigo Paz argues that we have seen the turning of the China tide that emerging markets have ridden during the past decade, thanks to regime change and the switch from an export to a domestic economic engine. “That inflection point was last year, not this year,” he says.

Over the past 12 years, a lot of growth among emerging-market commodity exporters and manufacturers was driven by Chinese investment. Many countries looked good with little effort – Brazil is a good example.

“A lot of the Lula miracle arose because the global environment was improving,” says Trigo Paz. “Even Argentina, which shot itself in the foot, was bailed out by that tide.
Post-2008, the China steamroller had a greater impact on emerging markets than QE-driven portfolio money. Last year the EM sell-off was driven by Europe, but the storm that lay behind that was China. We believe this will play out for the next two years unless China feels it has to undertake some stimulus for its own good. They are targeting 7.5% growth; we have to see how they will achieve that.”

The second theme that Trigo Paz raises is the issue of volatility. Jan Dehn at Ashmore, complains that investors tend to equate volatility with risk, which, he argues, is more properly about loss. One result of this tendency is that financial markets can be whipsawed by the impact of investors basing decisions on historical return and volatility relationships above fundamental analysis.

At the start of 2013, a 5.5% yield, volatility at 3%, duration of five years and the possibility of some FX appreciation made local-currency debt very compelling relative to the rest of the fixed-income complex. But when Bernanke’s tapering comments made volatility shoot up to 9%, investors questioned whether 5.5% was still enough to pay for that extra ‘risk’.

“Local-currency markets need to pay 7.5-8% to become attractive again for many investors, if volatility stabilises at 5%, for example,” says Trigo Paz. “As of mid July, we have another 100bp to go before we reach this level.”

The third key theme has been the impact of more short-term-oriented investment flows, which have caused what Trigo Paz describes as “surrealistic” market pricing. At the end of 2012 investors expected 20% return on emerging market equities and 5% FX appreciation on top of the 5-7% yield from local currency debt. That led to record inflows into emerging market funds in the first two months of 2013. But then we saw a period during which Japan embarked on a huge QE and stimulus programme while the Fed hinted at tapering its own, returns to emerging currencies turned negative and commodity prices remained subdued.
Emerging markets, which had been an unambiguously positive beta trade into the QE story, seemed to have become negative. Outflows in early summer were as big as inflows in late winter – and the volatility already discussed was the result.

“Rather perversely, investors buy at the top,” notes Dehn. “We saw huge inflows of capital into local currency debt in Q1 2013 as long-only unleveraged investors perceived little risk.
The market at the end of Q1 was very exposed.”

Then, in March, the emergence of ‘Abenomics’ in Japan sent the Nikkei rallying as Japanese investors shifted from bonds to equities. Investment banks proclaimed that they were selling their JGBs to buy global fixed income – including EMD. Dehn thinks this was incorrect – Ashmore itself did not see any inflows and noted only small outflows from Japan – but leveraged hedge funds, in particular, moved into local-currency debt in April to position themselves for an anticipated flow from Japan, pushing the average yield down to 5.16%. Bernanke’s comments, made on 22 May, sent Japanese stocks plummeting as investors took profits and global risk appetite cooled off; the hedge funds were forced to dump their geared positions to avoid breaching their risk budgets.

“They can’t afford to maintain a portfolio strategy through the cycle as if their risk budgets get hit, they lose their jobs,” as Ganske puts it.

In other words, we saw a classic example of pro-cyclical liquidity.

“EMD is one of the most inefficient markets in the world and the reason is because of the behaviour of short-term momentum-driven investors and traders such as market-makers, hedge funds and cross-over investors,” says Dehn.

“We have had 12 consecutive years of inflows into EMD,” adds Trigo Paz. “In the first half of 2013 there were outflows from investors exiting the beta trade, but institutional investors with a 5% allocation in their benchmark will be seeking the alpha trades in emerging markets.”

None of this is to deny that there are structural issues that need to be addressed in many emerging countries, beyond the development of deeper and more efficient financial markets. In particular, as many individuals reach middle-income status they are finding that those parts of the population that feel they have not seen any real benefits from economic growth are taking to the streets, whether in Brazil, across the Arab world or in Turkey. But short-term efforts to address social discord are often likely to be inflationary, without solving the underlying fundamental problems.

Moreover, as Trigo Paz warns, countries are now losing reserves as real portfolio flows become negative and commodity prices depreciate. Balanced against that, governments and central banks have shown that they can rapidly react to changes in the external environment. Brazil, for example, has removed its tax on portfolio investment. More broadly, capital controls have been relaxed and countries have started seriously to compete for portfolio flows. India is increasing quotas for foreign investors and Indonesia is raising rates, for example.

Separately, investors may perceive currency risks to be too great in emerging markets and ponder on the impact of Abenomics and a possible currency war. Dehn sees these fears as misguided. “Currencies are remarkably range-bound and ultimately have to be driven by changes in fundamentals – GDP growth rates, interest rates and expected inflation rates,” he says. “Nothing unexpectedly dramatic has changed in these.”

However, Maurice Meijers, emerging market debt manager at Robeco, does point out that emerging market currencies have not fared as well as one would have expected, given the growth of their economies over the past few years.

“What this reflects is the overall low level of global growth and the fact that emerging market currencies are dependent on seeing strong growth in the US and Europe, as well as in their own economies,” he says.

That leads him to reiterate the widely-held view that the decision on debt investment should be separated from the decision on currency. What could conceivably cause massive disruption to currency markets would be movements of the trillions of US dollars’ worth of emerging market central bank foreign exchange reserves. However, as Dehn points out, central bankers are keenly aware that their duty is to preserve the status quo and ensure stability in the capital markets. “They are just like judges who have the role of ensuring social stability through enforcing a set of laws,” as he puts it. Instead, he sees volatility in emerging market exchange rates as driven by relatively small amounts of portfolio flows.

That raises the question of how exposed different markets are to those volatility-inducing flows. The bulk of local currency debt is held by local insurance companies and pension funds that are often not allowed to invest elsewhere. Only 20-30% is held by foreigners. Pushing that proportion up can benefit countries by pushing their yields lower, but foreign ownership above 50% can be dangerous for financial stability.

Branet sees the 20-30% range as an acceptable equilibrium, but the current average disguises wide variation between markets.

“South Africa has been dominated by foreigners, and Peru had more than 50% foreign ownership at one time, which has given rise to instability,” she says. “Malaysia also had high levels but this was predominantly from other Asian investors who formed a stable investor base. In China and India, foreign ownership is close to zero. In Europe, Hungary has high levels, while in Poland and Turkey it is around 20-30%.”

As US Treasury yields rise, pushing up the yields in emerging markets in turn, countries with high financing needs – such as Venezuela and Ukraine – combined with large foreign ownership of debt, will suffer more as they come to refinance. They may find buyers, but at the cost of locking in much higher yields. By contrast, countries like Russia, which has nearly $500bn of FX reserves, are in a stronger position.

“Russia has budgeted for a $7bn bond issue but is delaying it, as it doesn’t have to come to market,” notes Branet.

Active managers are forever telling investors that the environment is rich in alpha and the cheap-and-easy beta trade is dead. In emerging markets – and particularly emerging-market debt – there may actually be something to that claim. Fundamental strength is beginning to tell in terms of relative performance. That does not mean that the strongest credits will not experience greater volatility from here onwards: they will, but it will be their fundamental strength – and particularly their reserve positions – that enables them to come through that volatility without it becoming a re-financing or balance-of-payments crisis. If they also use that volatility as a market signal to push forward with political reform disciplines, these selected credits and their currencies still look like very compelling long-term investments.

 

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